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Concentration, Consensus

Concentration Overtakes Conviction in 2018

Associate Editor

The Concentration Index has surged this year. Here’s why that may not be surprising—and why it probably won’t last.

Anyone paying attention to the Novus 4C Indices will have noticed that the Novus Concentration Index has stolen the spotlight from its three peer indices in 2018, as well as from the Hedge Fund Universe as a whole.

Hedge Fund Factor Returns 2018

 

 

Background

The trend is noteworthy in part because we typically watch the Novus Conviction Index lead the pack, as it did in 2017. Consider the long term performance of these two indices below—Conviction above, Concentration below.

The Conviction Index tracks the 20 stocks with the highest number of managers invested with conviction. The data shows us that high conviction by hedge fund managers usually signals strong performance.

Novus considers a stock that accounts for a significant portion of a manager’s portfolio an investment with conviction. While the exact percentage that qualifies is proprietary, it’s important to note that Conviction is not just the heavily trafficked names by number of hedge funds (like our Consensus Index), nor is it based on liquidity (like our Crowdedness Index).

The Concentration Index, the fourth member in this alliterative family of indices, tracks 20 stocks for which hedge funds make up the highest percentage of their outstanding shares—in many cases more than 60%. Stocks with heavy hedge fund ownership tend to be more volatile than other shares. When hedge funds hold a big chunk of a company’s stock, there’s more risk of crowd selling as hedge funds follow each other’s leads.

The Concentration Index’s standard deviation over the time period shown above is 20.72, compared to 11.88 for the S&P 500, and about 14 for the Conviction, Consensus, and Crowdedness Indices.

The standard deviation is evidentiary of how the Novus Concentration Index’s returns tend toward extremes. From 2010 through mid-2015, the Concentration Index steamed past broad indices such as the S&P 500. But that trend reversed in 2015, and the Index slumped for several years relative to the broad market.

2018 Upset

The Novus Conviction Index this year (see below) has behaved genereally as expected, hovering above the S&P 500 through the market’s ups and downs. Even after a very challenging October, the Index gained nearly 4% through the first 10 months of 2018.

But that’s no match for the Concentration Index (see below) which starting in early May rocketed past the S&P 500 and other 4C Indices. The index hit a high of 38.15% YTD return in September, and still leads the pack even after a 14% drop in October.

Breaking it Down

Why the surge? Healthcare seems a likely explanation. Healthcare is the Concentration Index’s largest sector exposure, at about 24%, with most of those holdings in the pharma and biotech industries.

Concentration Index Sector 2018

Slicing by exposure, we can see that heavy allocation to healthcare has paid off, contributing 1,163 bps of the total 1,941 bps in the portfolio.

While we’ve written recently about how hedge funds are flocking to biotech, another factor worth noting is the national conversation around drug pricing. Drug makers have faced widespread scrutiny over pricing in recent years. In May of this year, however, President Trump delivered a healthcare speech that, as The New York Times noted, “largely avoided the issues the industry fears the most, such as allowing Medicare to directly negotiate drug prices, or allowing Americans to import drugs.” Investors cheered Trump’s speech and sent drug stocks higher, and hedge funds rode the wave.

The Conviction Index, on the other hand, is composed of nearly 60% Information Technology names.

Conviction Index Sector 2018

Compared to the rest of the sector, the specific IT constituents in this index have underperformed in 2018. As The New York Times points out on the very day this article is being published, “The mighty tech titans and their seemingly endless pipeline of profits, which powered one of the longest bull markets in stocks, are looking a little less invincible.” The Novemeber 19th article says slowing growth, trade war with China, privacy concerns, security issues, and mismanagement are contributing to the slipping share prices of companies like Facebook, Amazon, Google, and Apple—all constituents in the Novus Conviction Index.

The Conviction Index’s main contributor (in bps) this year has actually been Consumer Discretionary, which accounts for one fifth of the names in the portfolio.

Conclusion

Rising pharma stocks aside, the Concentration Index’s leadership shouldn’t be too surprising: its high-octane nature tends to mean that when it’s good, it’s great, and its sector concentration means that it’s likely to benefit when its favored sectors shine. Likewise, no one should be shocked that the index dipped along with the rest of The 4C Indices in October—or if it continues to fluctuate dramatically in the months ahead.

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